Harrisburg Tire Company (HTC) forecasts the following for 2007. Earnings (net income) = $600M Dividends = $120M Interest expense = $400M Tax rate = 40% Depreciation = $500M Capital spending = $800M Total assets = $10B (book value and market value) Debt = $4B (book value and market value) Equity = $6B (book value and market value) The firm’s working capital needs are negligible, and they plan to continue to operate at their current capital structure. The firm’s estimated earnings growth rate is: A) 8.0%. B) 4.8%. C) 6.4%. D) 10.0%. -------------------------------------------------------------------------------- The forecasted free cash flow to equity is: A) $420M. B) $300M. C) $480M. D) $540M.

A1 .g=[(600 -120)/600] *[600/6000] = 0.08 = A? A2. 600 - [0.60*300] - [0.60*0] = 420 = A?

- (1-(120/600))*(600/6000) = 8% 2. 600 - .6(800-300) = 420M

Nice work guys. What am I missing on the second part: FCFE=NI+NCC-FCInv-WCInv+net borrowing FCFE=600=300-800=300 Tax stuff, but why doesn’t the formula hold. What’s my prob?

Hi mwvt9, To maintain the target capital structure of 0.40 we will need to have a net borrowing of 300*0.3 = 120 So, FCFE=NI+NCC-FCInv-WCInv+NB FCFE = 600 + 500 - 800 + 0 + 120 = 420

600+500-800+(.4(800-500)) = 420 Don’t know why it works, but net borrowing = FCinv less depreciation times the DR does.

dinesh.sundrani Wrote: ------------------------------------------------------- > Hi mwvt9, > > To maintain the target capital structure of 0.40 > we will need to have a net borrowing of 300*0.3 = > 120 > Can you explain that a little further? > So, > > FCFE=NI+NCC-FCInv-WCInv+NB > FCFE = 600 + 500 - 800 + 0 + 120 = 420

We have to maintain the Capital Structure ratio of D/TC = 4/10 = 0.4 and CAPEX this year = FC - DEP = 800 -500 = 300 so next year, they will have to have a thirst of the the same amount of CAPEX. i.e they will be needing 300$ of extra $$ off which they will finance some from debt and other from equity. The amount financed from debt will be 0.40*300 = 120 … hence that becomes the net borrowing. Hope I am correct…

If you think about the concept instead of the formula it might help. Here is how I did it. I took NI to a pre-tax level, added depreciation and then taxed that amount. (1-tax) = .6 600/.6 = 1000 1000 + 500 = 1500 1500*.6 = 900 Then we had capital spending of $800 but only 60% of that was funded from equity, the rest was funded from debt. So 800*.6 = 480 Then we have the 900 - 480 = $420

ok so I am thinking that for forecasted FCFE we use the formula FCFE = NI - (1-DR)(Net FCinv) - (1-DR)(WCInv) = 600 - (1-0.4) ( 800 - 500 ) - 0 = 600 - (0.6 * 300) = 420

Okay. So all new investment FCInv and WCInv (even though not in this question) will be financed with a combination of equity and debt. So we have to figure out what the total amount spent is and if there is borrowing then plug it into FCFE. Does that sound right?

mv, it’s asking for forecasted FCFE, which has the different formula. i didn’t catch that either.

hey mwvt9, what does the solution say?

A. A.

ok…is there any explation for the answers?

I will get to them. I am in the midddle of a q-bank. Back to you soon.

ok

Harrisburg Tire Company (HTC) forecasts the following for 2007. Earnings (net income) = $600M Dividends = $120M Interest expense = $400M Tax rate = 40% Depreciation = $500M Capital spending = $800M Total assets = $10B (book value and market value) Debt = $4B (book value and market value) Equity = $6B (book value and market value) The firm’s working capital needs are negligible, and they plan to continue to operate at their current capital structure. The firm’s estimated earnings growth rate is: A) 8.0%. B) 4.8%. C) 6.4%. D) 10.0%. Your answer: A was correct! The firm’s estimated earnings growth rate is the product of its retention ratio and ROE: g = RRx(ROE) = [(600 - 120)/600]x(600/6000) = 0.08 -------------------------------------------------------------------------------- The forecasted free cash flow to equity is: A) $420M. B) $300M. C) $480M. D) $540M. Your answer: B was incorrect. The correct answer was A) $420M. Since working capital needs are negligible, the free cash flow to equity is: FCFE = Net income - [1-DR)] x [FCInv - Dep] - [(1 - DR) x WCInv] = FCFE = 600M - [1 - (4/10)]x(800M - 500M) = 420M where: DR = target debt to asset ratio

good questions …

Niblita75 Wrote: ------------------------------------------------------- > 600+500-800+(.4(800-500)) = 420 > > Don’t know why it works, but net borrowing = FCinv > less depreciation times the DR does. I don’t either! In schweser they highlight that FCInv=capital expenditures-proceeds from sales of long-term assets where capex=ending GROSS PPE-beginning GROSS PPE. So why are we using depreciation to figure out FCInv?